End of LIBOR: A Rising Challenge for The Insurers

Insurance| Risk| Regulations| Solvency II| Volatility| News

Published: 2019-02-15

Driven by the daunting consequences of the global financial crisis in 2008 and the LIBOR scandal in 2012, the world’s financial regulators established that there was a need for the development of alternative reference rates that could better reflect the underlying market and would be more difficult to manipulate. Since financial institutions use the reference rates to design contracts of various kinds, the impact of this change will be considerable (1). However, most of the available analysis and other material on this topic describe the challenges of such a transition only for banks, frequently leaving out the insurers who are significantly affected by the change as well. Therefore, it becomes essential to highlight global best practices regarding the preparation for replacing the -IBOR in the insurance industry.

According to the Financial Stability Board, the new benchmarking alternatives were suggested to be transaction-based and meet the International Organisation’s of Securities’ Commissions (IOSCO’s) principles for benchmarks. Besides, there should be several types of reference rates in one currency, so that different types of actors would be able to choose the instrument that suits them best (1). In the context of the insurance industry, the transition from -IBOR would affect the discount rates used in the valuation of insurance contracts – which would result in a higher P&L volatility (variability in income statements) (2). Moreover, the transition will affect the asset side of the balance sheets as well, the valuation of the derivatives held by the insurers would have to be reviewed as it is likely there will be an impact on the valuation of any -IBOR-linked derivatives held by the insurer (4). Finally, the change of the reference rates will affect the syndicated loans and floating rate notes held by the insurance companies – which also impacts the value of the balance sheet items (5). Therefore, it is important for the insurers to understand the risks associated with -IBOR transition and any dependencies on Solvency II requirements (3).

The supranational EU regulation on reference rates (Benchmark Regulation, BMR) that came into force on 1 January 2018 postulates the requirements for those who administer and report reference rates. As a result of the law, the rules became stricter and the financial regulators of several countries (the USA, the UK, Japan, Switzerland, the EU) have come up with alternatives to the benchmarks which no longer met the requirements (1). Although Sweden has not yet begun the transition from STIBOR, the Swedish benchmark rate, it is a good idea to review the experience of the leading countries in implementing the BMR.

The British Government have shown a high degree of proactivity in preparing the UK’s financial industry for the transition. The working group of private companies and institutions aimed at identifying a reliable alternative to LIBOR and ensuring a smooth transition to it was appointed as early as 2015. In 2017, the working group presented a proposal for how to switch to an updated version of the reference rate – Sterling Overnight Index Average (SONIA). In that same year, the FCA, which acted as an observer in the steering group, announced that it does not intend to support LIBOR after 2021.

Furthermore, in late 2018 a letter from Bank of England urged the British insurers to study the risks associated with the transition and to take appropriate actions to secure a sound conversion to alternative rates ahead of the end-2021 deadline (3). In this letter, the regulator reminds the insurance companies’ executives that Solvency II requires the industry to discount liabilities using risk-free rate curves that are in many currencies currently derived from LIBOR. Moreover, Bank of England underlines the importance of the issue by highlighting that the monitoring of the LIBOR transition has been added as a topic to the European Insurance and Occupational Pension Authority’s (EIOPA) general work on insurance risk free interest rates (RFRs). The British regulator argues that the firms should understand the risks of the replacement process and any dependencies on Solvency II requirements, including in relation to EIOPA’s work.

As a response to the letter, the regulators requested the boards to hand in summaries of their risk assessment concerning the change as well as appoint senior managers within the firms who would oversee the implementation of the LIBOR replacement.

In the report (1), the Swedish Financial Supervisory Authority expressed confidence that the transition from STIBOR will eventually take place, stressing that the replacement process would be costly, risky and could take several years for the financial institutions to complete. At the moment, the Swedish Bankers’ Association (in cooperation with the regulators) created a working group dedicated to the search for potential STIBOR alternatives. The corresponding work is anticipated to be finished by the end of 2019 (6). Besides, the Swedish Financial Supervisory Authority emphasises that it is crucial to learn from the -IBOR transition experience of other countries. Thus, it would be beneficial to Swedish insurers to follow the advice of the British financial authorities and begin the discussion of potential risks associated with the transition and their implications on the compliance with the Solvency II framework.